Collateral Management

Warehouse Receipts and Collateral Management Presentation to FICCI New Delhi 17th July 2004 Agenda Current Status of Warehouse receipts Issues before Lenders Exchange physical settlements ‘Collateral Management’ concept Role and Functions of Collateral manager Risks and mitigants Efficient commodity markets Multiple buyers and multiple sellers Price discovery platform Price dissemination Transparent clearing and reliable settlement Spot and Futures markets Commodity based credit Commodity based tradable warrants Essential elements for efficient post-harvest markets Commodity based finance and warrants Policy environment Market information support Recognition of trader State as facilitator and regulator Stable and low interest rates No controls on stocking, movement and prices Legal framework Contractual rights of parties protected Facilitate trading in warehouse receipts Enablers by and large in place Commodity based finance and warrants Institutional framework Sound banking system Futures exchanges Price stability Network of warehouses Collateral Managers The concern is on warehouses and collateral managers Warehouse receipt Document stating the ownership of commodity Specified quantity, quality and grade Warehouse location , storage fee etc. Can be sold or used to raise a loan Used for delivery against a derivative instrument like futures contract Converts agricultural produce or other inventory to a tradable warrant Legal status of warehouse receipt Conventionally accepted as a ‘document of title’ Transferability contingent on terms and conditions of issuer or by law Generally issued as transferable receipt Not a bearer instrument Need endorsement for transferring the rights Notice of endorsement need to be submitted to warehouse Non-negotiable instrument Limited usage in India; conventionally low status even in comparison to B/L, AWB, R/R and L/R Key issues in current warehouse receipt structure Warehouse receipt not a negotiable instrument in India Transfer of title is possible with endorsement But title not free from any outstanding claims Weakens its status as a ‘security interest’ Low credibility of the ‘warehouse' issuing the receipt No independent warehouse accreditation body Lack of Performance guarantees and reliable insurance cover Confidence in quantity and quality of underlying commodity Credibility of warehouse receipt needs to be enhanced Prerequisites for negotiability status Grading standards for commodities Market’s confidence in the warehouse operators Independent approval or accreditation Insurance and performance guarantee External supervision and monitoring Confidence in quality and quantity of stock Circulation of genuine receipts Easy transferability of commodity ownership Electronic holding of commodity balances Collateral Manager as an independent and expert third party? Key enablers for warehouse receipts Negotiability status of the warehouse receipt Collateral management services Grading, quality, quantity and weight controls of the underlying physical commodity Process controls at the warehouse Insurance, legal and financial structures Protection of the marketable value of the collateral Secure electronic warehouse receipt system Mitigates the risk of physical tampering More checks enabled by the multiple parties Commodity information secure with depository Warehouse receipt system with Collateral manager Deposit commodities Farmer/ Trader Farmer/ Trader Warehouse 1 Warehouse 1 Bank Finance Deposit commodities Collateral Manager Collateral Manager 2 2 3 3 4 4 5 5 Warehouse receipt Lender Lender Warehouse receipt Commodity Exchange Commodity Exchange Currently Rs 70 bn exposure by lenders as against annual agro commodity size of Rs 11,000 bn Indian Collateral Management Spectrum Clients Lenders Commodity exchanges Vendors Warehouses Logistics players Grading , assaying & Certifying firms Transporters C & F agents Farmers Traders Processors Distributors Exporters Importers Collateral Warehouse Management Accrediting Agency Depository Agency DPs and R & T agents State Procurement Agencies Marketing Agencies Why banks do not lend against commodities ? Price risk - no mechanism for hedging commodity price Credit risk - inadequate structures to transfer risk from borrower to commodity Operational risk – poor state of warehouse management process and control on collateral Inadequate and irregular MIS on stock holdings Curtailed lending against warehoused commodity- limited credit flow to agriculture How Lenders manage collateral? Bilateral arrangement No third party guarantees Ineffective stock verification Lack of control on funds and material flows No control over logistics No disposal plan Risks and concerns for Lenders Lower credit rating of assets Larger capital adequacy Impaired assets – even where credit risk is not the issue 90 day NPA norm makes the going tougher Curtailed credit flow for borrowers – especially SME and Agro sectors Non fulfillment of sectoral lending Present task of NCDEX in physical delivery Specify/evolve commodity specific norms for accrediting warehouses Accredit the warehouses in each delivery center Enter into agreement with diff. WH at different delivery centers Arrange quality certifiers and assayers to verify the compliance of contract specifications at the time of deposit Notify the accreditation of the ware house formally. Periodical Monitoring Not core functions of Exchange but essential to facilitate physical delivery Warehouse accreditation norms Financial soundness Positive net worth of minimum Rs. 1 crore Sound management practices Technical parameters construction as per BIS / FCI stipulations Accessibility – free access by road and/or rail Least affected by natural calamities flood, landslide etc. Availability of requisite labour and other facilities weigh bridges, packing facilities etc. NCDEX physical settlements The Exchange offers trade on 12 agricultural commodities apart from gold and silver Around 10 new commodities under consideration Recent contracts with the feature of ‘seller’s option’ More physical deliveries expected multiple contracts at multiple centers More deliveries likely to boost Exchange volumes Robust and large scale arrangements required Over the next 2-3 years, Exchange would need access to around 500-600 warehouses Drawbacks With expanding volumes, the Exchange is increasingly required to : Ensure adequate accredited warehouse space No commitment charges paid Ensure availability of timely service of assaying and quality certifying agencies Ensure coordination of the multiple logistics providers Ensure tracking of commodity quality, quantity and weight Undertake accreditation of the multiple agencies Drawbacks lead to operational risks which need to be mitigated Concept of Collateral Management Collateral is an asset or a third-party commitment accepted by the collateral taker to secure an obligation of the collateral provider. “Collateral” has the same meaning as “security” Used to avoid confusion with stocks, shares, etc. Transaction intended to protect against performance risk of counter party. Collateral Management involves managing the collateral on behalf of the collateral taker Global Scenario Large role in cross-border movement and trade of commodities Specialize in servicing mortgage loan requirements as well as financial collateral Valued high where the infrastructure is poor and regulatory monitoring and compliance are wanting Enable warehouse receipt financing by mitigating operational risks and upgrading credit rating Proposed role of Collateral Manager in the Indian context Ensures adequate accredited warehousing space Ensures quality and quantity of warehoused goods Backs the same with guarantees and insurance Provides in-bound and outbound logistics support Advisory and Inventory Management services Provides on-line and accurate reporting Facilitates disposal of collateral, when necessary End-to-end collateral risk management solutions and services for lenders, commodity exchanges and others Functions and responsibilities of a Collateral Manager Identification of potential risks and its mitigants Due diligence to set up a secure structure Accreditation / grading of warehouses Technical specifications & Financial evaluation Provision of warehousing space Producers/Traders/Processors, commodity exchanges Empanelment of graders / certifiers Farm-gate to FOB handling services Facilitating structures for commodity lending Electronic systems for control and monitoring Arranging of 24/7 security Insurance tie-ups and adequate liability coverage Collateral manager- benefits Clients Lenders Commodity exchanges Farmers Traders Processors Distributors Exporters Importers Expands the credit portfolio based on warehoused commodities / materials Mitigates operational risk in credit decisions Throws up early warning signals on the banker’s screen Losses can be controlled at an early stage Enhances portfolio credit rating Enables bankers to focus on financials and credit risk rather than logistics Lender’s concerns addressed Price risk Hedge price risk on commodity exchanges Credit risk Collateral manager assist in effective credit risk management and due diligence Operational/Performance risks Offloaded to the professional Collateral Manager Legal / litigation risks Reduced ; Collateral Manager ensures proper documentation, adequate insurance cover etc. Structured Commodity Based Financing Structured form of financing with the objective of transferring risk from entity to a commodity Soya loans; CPO loans Secured exposure on borrowing entity wherein security is commodity Borrower Borrower risk Collateral manager Finance Commodity Lender can hedge his price risk on NCDEX Lender Commodity risk CBF will imply greater finance for the borrower and less risk to bank Advantages of CBF + CM Raw material prices are locked thereby hedging risks Leverage collateral Attractive pricing through structuring Financing in convenient tranches Aligned with the stock build-up schedule on raw material as the primary Can be structured as off-balance sheet funding Collateral manager-benefits Clients Lenders Commodity exchanges Farmers Traders Processors Distributors Exporters Importers Increase in physical deliveries Wider participation by growers and processors One stop service to mitigate operational risks Spot trading and deliveries enabled Access to markets and better infrastructure Reliance on market mechanism-reduced dependence on government Better price, staying power and lower borrowing costs Finance readily available at lower cost Larger level of operations Collateral manager-benefits Clients Improved supply chain Lenders Commodity exchanges Quality, quantity and weight checks Inventory / commodity based borrowing at better terms Inbound and outbound logistics support Improved MIS - better inventory management Domestic and overseas logistics Better coverage of insurable risks Farmers Traders Processors Distributors Exporters Importers Risks and mitigants for the Collateral Manager Legal backing to accreditation Work with reputed rating agencies Negotiability of Warehouse receipts Law under drafting Electronic holding of balances Operational risk management in rating enhancement structures Monitoring and inspection mechanism Pioneering concept- market acceptance Need for lenders and exchanges to expand business New concept- hard selling needed Credibility to be built up from the ground National Collateral Management Services Limited (NCMSL) The first national level Collateral Management company to be set up in India Confirmed institutional promoters: NCDEX Audit Control & Expertise (ACE) ICICI Bank Canara Bank Corporation Bank Punjab National Bank Other interested institutions : Indian Farmers Fertilizer Co-operative Limited (IFFCO) HDFC Bank Provide end to end collateral risk management solutions Looking Ahead Current lending against commodities by Indian commercial banks is just Rs 70 bn Expected to grow 5-7 fold over next 3 years Technology and risk mitigants – key enablers Emerging investment diversification Next perceived boom after retail lending Thank You